Global tensions don't dent enthusiasm for stocks

Saturday, July 26, 2014

A war breaks out between Israel and Hamas. An airliner is shot out of the sky in Ukraine. A Portuguese bank's finances look shaky.

And the U.S. stock market's response? After dipping briefly on the bad news, it climbs higher.

The market's resilience this year — which has pushed it to a series of records and extended its five-year bull run — is driven by investors' optimism over the growth of the U.S. economy and record corporate earnings. That helped the market overcome its latest dip, on July 17th, when a passenger jet was shot down in eastern Ukraine and Israel invaded the Gaza Strip, raising investor worries that conflicts around the world could escalate and destabilize financial markets.

As they have all year, investors responded by using it as an opportunity to buy stocks. In fact, they've "bought on the dip" consistently for three years, keeping the market's slips from becoming slides. Stock pullbacks since 2011 have been rare and relatively small, and none have become severe enough to qualify as a correction, Wall Street parlance for a fall of 10 percent or more from a peak.

The lack of a correction for such a long period is unusual, because the Standard & Poor's 500 index experiences such a decline on average every 18 months, according to S&P Capital IQ research.

Many investors say that the uninterrupted rally is justified by the outlook for stocks. Central banks worldwide have policies in place aimed at stimulating economic growth, and U.S. corporate profits continue to rise, even in the first quarter, when the economy contracted.

That has driven the S&P 500 up 7 percent this year, not including reinvested dividends. That's on top of a 30 percent surge in 2013. The index closed Friday down 0.5 percent at 1,978.34, after closing at a record 1,987.98 a day earlier.

"The fundamental underpinnings of this bull market remain very much intact," says Katie Nixon, chief investment officer for wealth management at Northern Trust.

In the U.S., the Federal Reserve has held short-term interest rates at close to zero for almost five years, and has bought $3 trillion of bonds to hold down long-term rates. The Fed has been winding down its stimulus, but a rate increase isn't expected until at least 2015.

The European Central Bank in June introduced a raft of unusual measures meant to revive the eurozone economy by getting credit flowing to companies. Japan's central bank is also trying to stimulate that nation's economy.

While these policies have cut borrowing costs, they have also reduced the yields on bonds — and the income they generate for investors. As a result, investors have shifted their money to other assets, such as stocks, in the hunt for better income. That dynamic has supported the rally in stocks.

Utilities, which are regarded by some investors as a proxy for bonds because they are relatively stable and pay rich dividends, are the biggest gainers in the S&P 500 this year. Their dividend yield — which measures how much a company pays out in dividends each year compared with its stock price — stands at 3.5 percent. The yield on the 10-year government Treasury is 2.5 percent.

The stock market could suffer a sharp, but short, correction later this year once the Fed finishes withdrawing its stimulus and investors start to focus on when exactly the central bank will begin raising interest rates next year, says Robert Pavlik, chief market strategist at Banyan Partners.

"The market is going to focus more and more on when the Fed moves," said Pavlik. "That's the biggest chance for a correction to come at us."

But for now, investors are focused on company profits, and the outlook remains strong. Earnings for S&P 500 companies are expected to climb 7.8 percent in 2014, their fifth straight year of growth, helping investors overcome concerns about the Fed and rising political tensions.

"People are looking for something to justify a significant correction,'" says Dan Morris, global investment strategist for TIAA-CREF. "Yes, volatility is going to come back, that's obvious, but in terms of any kind of 10-plus percent correction, we just don't see it."

The S&P 500 index has risen almost 72 percent since the end of the last market correction in October 2011. It has closed at an all-time high 27 times since the start of the year.

Stocks have managed to rise even as the outlook for growth weakens.

The International Monetary Fund said Thursday that the global economy expanded less than it had previously forecast, slowed by weaker growth in the United States, Russia and developing economies. The lending organization predicted that global growth will be 3.4 percent in 2014, below its April forecast of 3.7 percent.

In Europe, growth is recovering but weak. During the first quarter of 2014, the eurozone grew by a paltry 0.2 percent.

Last week's market action, a big dip followed by a quick rebound, has happened on other occasions this year.

The S&P 500 slumped 1.2 percent July 17, the biggest one day drop in more than three months, as investors worried that geopolitical tensions would escalate after a Malaysian airliner was shot down over rebel-held eastern Ukraine. But instead of marking the start of a wider decline, the market rebounded on Friday as investors focused on strong corporate earnings in the U.S.

Stocks also fell on July 10, although to a lesser degree, following worries about the soundness of Espirito Santo International, a holding company that is the largest shareholder in a group of firms, including the parent of Portugal's largest bank, Banco Espirito Santo. The specter of a European debt crises prompted investors to push down the stock market 0.4 percent and snap up less risky assets like gold and governments bonds.

And in June, after a breakaway al-Qaida group seized large swathes of territory in Iraq and Syria, threatening to destabilize the entire region, stocks managed a 1.9 gain for the month.

In April, stocks plunged as investors dumped biotech and Internet stocks. The technology-heavy Nasdaq composite index slumped to its worst day since 2011 and dragged down other major indexes. Between April 3 and April 11 the S&P 500 dropped 4 percent, but by the middle of May the stock market had recovered and was trading at record levels again.

The biggest one-day drop of 2014 was on Feb. 3. The index slumped 2.3 percent, falling to its lowest level of the year, as investors worried about the outlook for global growth and the impact of an unusually harsh winter on the U.S. economy. Since then the S&P 500 has gained 5.2 percent.

While those drops were significant, they pale next to the losses experienced during a correction.

During the last such slide, which ran from April to October 2011, the S&P 500 declined more than 19 percent on concerns about the fallout from Europe's debt crisis and impact of the U.S. government's credit rating being lowered.

Northern Trust's Nixon says that it's only natural that the longer the market goes without a correction, the more investors will worry that a sell-off is imminent and avoid buying stocks.

In fact, the bigger risk to investors, Nixon says, is that they don't buy stocks and miss out on the market's gains at a time when holding cash offers a return close to zero.

"A correction is a natural and normal part of the market cycle and it shouldn't be feared," says Nixon. "Waiting for a correction is an expensive game right now."